Strong Brands Fuel Growth & Cut Risk

Fast-food stocks have been among our biggest gainers since the 2002 stock market slump. Despite increasing concerns over nutritional content, Americans are eating more of their meals outside of the home. Fast-food is also an increasingly affordable luxury in developing countries.

However, rising gas prices could cut customer traffic and put a damper on profit growth. Rising food and labor costs will also squeeze margins.

We designed our system to zero in on fast-food companies whose strong brands and market share will help them overcome these setbacks. Here are three top examples.

MCDONALD’S CORP. $51 (New York symbol MCD; Conservative Growth Portfolio, Consumer sector; Shares outstanding: 1.2 billion; Market cap; $61.2 billion; WSSF Rating: Above average) operates over 31,000 fast-food restaurants in 120 countries. Overseas operations account for two-thirds of its sales, and 40% of profits.

The company owns about 25% of its restaurants, but aims to convert them into franchises over the next few years. Consequently, it recently sold 1,600 of its outlets in Latin America and the Caribbean. It received $700 million in cash, but recorded a non-cash $1.6 billion loss on the sale.

We think the sale makes sense. Local owners have a better knowledge of local tastes, and can adjust their menus to maximize sales. They will also assume responsibility for capital spending.

If you disregard the loss on the sale, McDonald’s earned $0.71 a share (total $869.9 million) from ongoing operations in the second quarter of 2007. That’s a 26.8% gain over the $0.56 a share ($698.3 million) it earned a year earlier. Sales grew 11.1%, to $6.0 billion from $5.4 billion, thanks to extended hours and successful new breakfast items. Same-store sales rose 7.4%.

The cash from the sale will help McDonald’s fund its plan to spend $5.7 billion on share buybacks and dividends in 2007 and 2008. It repurchased $664 million worth of its stock in the second quarter of 2007.

Instead of quarterly payments, the company usually pays its dividend once a year in December. It will probably increase last year’s payment of $1.00 a share by 20%, to $1.20. That implies a 2.4% yield using the current stock price.

Despite the higher buybacks and dividends, McDonald’s should have plenty of cash left for store upgrades and other growth projects. It could also raise cash by selling its remaining casual restaurant chains: Boston Markets in the U.S., and Pret a Manger in the UK.

The stock has quadrupled in the past four years, but still trades at a reasonable 19.3 times its forecast 2007 earnings of $2.64 a share.

McDonald’s is a buy.

YUM! BRANDS INC. $34 (New York symbol YUM; Aggressive Growth Portfolio, Consumer sector; Shares outstanding: 520.0 million; Market cap: $17.7 billion; WSSF Rating: Average) operates over 34,000 restaurants in 100 countries. Banners include KFC (chicken), Pizza Hut, Taco Bell (Mexican food), Long John Silver’s (seafood) and A&W (hamburgers).

Most of Yum’s recent growth has come from its overseas operations, particularly in China where it owns 2,300 KFC and 370 Pizza Hut outlets. This division now accounts for 20% of Yum’s revenue. Other overseas operations provide 30% of its revenue, while the United States accounts for 50%.

Thanks to a 7% rise in same-store sales at its China division, plus a 5% gain at its other international operations, Yum’s sales in the second quarter of 2007 grew 9.1%, to $2.4 billion from $2.2 billion. Same-stores sales in the U.S. were flat due to a food safety scare at some Taco Bell restaurants in the northeast.

Income in the quarter rose 14.7%, to $0.39 a share from $0.34 a year earlier (all per-share amounts adjusted for a recent 2- for-1 stock split).

It will probably take a few more months before sales growth resumes at Taco Bell. Meanwhile, Yum’s plan to open about 1,000 new restaurants in China and other countries this year should help offset slow domestic sales.

Like McDonald’s, Yum is converting its U.S. restaurants into franchises. Right now, franchisees own 78% of Yum’s U.S. outlets. That should rise to 83% by the end of 2008. The plan will give Yum more cash for share buybacks and dividends (the current rate of $0.60 yields 1.8%).

Cheese accounts for about 12% of Yum’s raw material costs, and rising cheese prices could hurt its profit growth. But earnings should reach $1.64 a share in 2007, and the stock trades at 20.7 times that estimate.

Yum Brands is a buy.

TIM HORTONS INC. $32 (New York symbol THI; Aggressive Growth Portfolio, Consumer sector; Shares outstanding: 189.7 million; Market cap: $6.1 billion; WSSF Rating: Extra risk) operates over 2,700 coffee-and-donut shops in Canada, and 340 in the United States. Franchisees operate 97% of its stores.

The company was a wholly owned subsidiary of Wendy’s International Inc. up until April 2006. That’s when it sold shares to the public at $23.162 each.

In October, Wendy’s handed out its remaining Tim Hortons stock as a tax-deferred dividend. Investors received 1.3542759 shares for every Wendy’s share held.

Few Americans have heard of Tim Hortons, but it has become a national icon in Canada. It recently surpassed McDonald’s as Canada’s largest fast-food chain in terms of stores and sales.

Much of the company’s growth comes from a steady stream of new products and innovative promotions. Recent moves to add submarine-style sandwiches, soups, salads and a hot breakfast sandwich have also cut its reliance on donuts.

In the first quarter of 2007, earnings fell 6.8%, to $59.3 million from $63.6 million a year earlier (all amounts except share price and market cap in Canadian dollars), due to a change in its tax situation.

The company had an unusually low tax rate of 14.8% a year earlier, due to write-offs associated with its initial public offering, compared with a more normal rate of 34.6% in the latest quarter.

Per-share earnings fell 20.5%, to $0.31 from $0.39, due to more shares outstanding. Sales rose 13.9%, to $424.6 million from $372.8 million. Same-store sales rose 6.3% in Canada, and 4.0% in the U.S.

The company has had trouble duplicating its success in the U.S. While its stores near the Canadian border are strong performers, its 40 stores in New England face strong competition from more-established chains such as Dunkin Donuts.

Tim Hortons may soon close these outlets if they continue to lose money. That would add roughly $0.07 a share to its annual income.

The stock has gained 38% since its initial public offering, and now trades at 20.9 times the $1.47 a share (Canadian) that it will probably earn this year. That’s reasonable in light of its leading market position in Canada, and strong growth record. The $0.28 (Canadian) dividend yields 0.9%.

Tim Hortons is a buy.